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An appreciation for hedging your bets on deferred compensation

Under Section 457A of the U.S. Internal Revenue Code of 1986 (the “Code”), certain offshore and other entities are limited in their ability to provide tax-effective deferred compensation to providers of services to those entities. Recently, in Revenue Ruling 2014-181 (the “Ruling”), the Internal Revenue Service (the “IRS”) confirmed that certain equity-based compensation arrangements are not subject to Section 457A. This article will discuss how the Ruling may present an opportunity for investment funds and their sponsors and managers to explore the use of certain types of equity-based compensation arrangements as a workable solution to avoid the restrictions of Section 457A and simultaneously accomplish their compensation-related goals.2

Background

Prior to the enactment of Section 457A, managers of various investment funds had been permitted to receive all or a portion of their compensation on a tax-deferred basis, often with the deferred amounts being effectively reinvested in the fund. In 2008, Congress added Section 457A to the Code to curb the use of deferred compensation arrangements by certain offshore and other entities not subject to a comprehensive tax regime. Section 457A effectively eliminated the ability of U.S. service providers to defer taxation on compensation paid by certain tax-indifferent service recipients. Many investment funds are subject to Section 457A and, as a result, efforts to defer fund-related compensation generally needed to be structured to avoid Section 457A.

Following the enactment of Section 457A, a number of approaches have developed in the market to accomplish the payment of tax-deferred compensation to certain fund managers. Some approaches have involved the use of partnership interests, which generally are not subject to Section 457A. Certain other approaches involve the use of compensation that is subject to vesting requirements, with the intention that the compensation not be considered “deferred” for Section 457A purposes.3 As a practical matter, however, Section 457A has, in a variety of cases, dramatically curtailed the ability of fund managers of offshore funds to defer compensation for tax purposes.

Revenue Ruling 2014-18

After the enactment of Section 457A, the IRS attempted to clarify that certain equity-based compensation is not subject to Section 457A. Specifically, in Notice 2009-084 (the “Notice”), the IRS indicated that certain types of stock options and stock appreciation rights (“SARs”) settled in stock are not subject to Section 457A.5 As a practical matter, in the context of fund-related compensation, SARs, rather than options, may be the more relevant type of compensatory interest.

After the Notice, there still seemed to be a general reluctance on the part of investment funds and their sponsors to adopt option or SAR arrangements intended to avoid the reach of Section 457A. It appears that, in light of the substantial adverse tax consequences under Section 457A, some in the market were unwilling to proceed absent further clarification.

Now, with the issuance of the Ruling, the IRS has confirmed that certain stock options and stock-settled SARs are indeed not subject to the restrictions of Section 457A. In addition, the principles discussed in the Ruling with respect to stock options and stock-settled SARs could be read in conjunction with the Notice to apply to other equity appreciation rights (“EARs”) that are settled in non-stock equity interests in non-corporate entities.6 In light of the foregoing, it would appear that the clarification provided by the IRS in the Ruling may be relevant to corporate and non-corporate entities alike, and therefore potentially relevant with respect to a wide range of investment funds.

Next Steps

While SARs and other EARs are not necessarily appropriate for all funds as a business matter, there may be funds for which such interests indeed accomplish the compensation-related goals of the fund, its sponsor and the manager. Indeed, there are indications that EARs may well also be desirable from the perspective of fund investors, as they can tend to align the interests of managers and investors.

If stock-settled SARs or other equity-settled EARs make sense from a non-tax business perspective, it now may be possible, with a greater level of comfort, to structure a tax-efficient program that permits a manager to defer its compensation. The following features are among those that funds and their managers may wish to consider:

In the case of an entity manager organized as a partnership for tax purposes, income from the exercise of SARs/EARs may be able to be allocated to the entity’s principals under their partnership (for tax purposes) interests.

There may be a wide range of vesting and other ancillary features that can be incorporated into the SAR/EAR arrangement, thereby potentially further increasing the utility of the arrangement from a design perspective. The breath of the possible design features that can overlay the basic SAR/EAR structure could be substantial, constrained primarily by non-tax business considerations.

It may be possible to cap upside returns, if there is a concern that the SAR/EAR could provide payments considered excessive as a business manner.

It may be possible to flow the economics of the underlying SARs/EARs to employees of an entity manager, using a plan involving short-term deferrals for Section 457A purposes (i.e., using a plan that does not provide “deferred compensation” for such purposes).

It may be worthwhile to consider whether investment relationships structured as separately-managed (or similar) accounts could be restructured through use of an entity (e.g., a “fund of one”).

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